The concept of write-down inventory states that the value of inventory should appear in financial statements only if it has some value, which is equal to the difference between the current market replacement value and the original inventory cost. IAS 2 stipulates that loss on write-down inventory if small should be reported as part of the cost of goods sold and if huge, it should be reported on a separate line on the income statement. It thus follows that an exclusion of write-down inventory may lead to investor overestimation of earnings persistence thereby leading to ethical and financial implications. The ethical issues include loss of brand value and goodwill, concealment of fraud penalties, and loss of shareholder and investor confidence while financial implications may include excessive compensation of the management.
It would be advisable for both the CFO and CEO of the company to consider the negative assessment by the IRS since the company used write down inventory to reduce its taxable income. The amount is inaccurate and is evidently used for tax purposes and was not included in the income statement as stipulated (Arens, Elder, & Beasley, 2006). The IRS thus would be compelled to contact the fraud technical advisor and the front line manager to ascertain the length of such an activity and thereby claim the tax payable in addition to fraud charges.
The CFO and CEO should identify any changes in operations that may have led to slow-moving or obsolete inventory. In case there are differences in the expected results, then an inventory turnover ratio analysis should be performed. Gross margin ratio analysis is also used to detect unrecorded inventory. It is thus the obligation of the CEO and the CFO to remove potential opportunities and pressures for committing frauds and avoid setting of unachievable financial goals. They should also set honest and ethical behavior in the organization and give employees an adequate training on the company standards, procedures, and policies with regard to ethical accounting behavior (Arens, Elder, & Beasley, 2006).
Negative Results of IRS Audit
Any possible inventory understatement or stock overstatement is illustrated in the IRS audit. In the company’s books, there was a decline in the statement of stock by 30 percent which affects shareholders value in the 3 periods due to inventory understatement. Moreover, this results in a reduction in the incomes for the 3 financial periods based on the cost of goods sold. The increase in tax obligations and penalties may lead to a reduction in the value of total liabilities accruable and earnings. Additionally, the penalties would be business expenses, therefore, requiring provision within the income statement as entity expenses.
Federal Tax Laws, Regulations, Rulings, and Court Cases on Inventory Write-Downs
Inventory is a crucial part of a company’s taxable income, therefore, if the company wants to reduce its taxable income, it can write down inventory as damaged, unsellable, or stolen. Federal tax laws allow companies to write off inventory lost in case of theft or disaster as well as the steps a company should follow to claim tax write-down for inventory. Taxpayers are allowed to deduct inventory’s decline in value from cost a lower market value. This adjustment is taken in the year of the decline although the inventory is not sold. Under section 471 of the Internal Revenue Code provides that inventory should be valued at cost and lower of market value or cost (Arens, Elder, & Beasley, 2006).
Moreover, the UNICAP rule of § 263A requires companies to exploit inventory additional costs expensed from financial accounting purposes. The market value of inventory is determinable on an item-by-item basis whereby similar inventory is used to determine the bid price. In Thor Power Tool Company v Commissioner Case of 1979, the U.S. Supreme Court upheld IRS regulations giving limits to how taxpayers could write down inventory. It was held that Thor would be denied the write-down since it did not demonstrate a market price of less than cost in addition to failure to show that the goods were subnormal. This, therefore, forbids companies from writing down inventory when not sold.
GAAPs Regarding Stock Option Accounting
Stock-based compensation plans are used by companies to reward and motivate managers and employees. Under the US GAAP on share-based payment, it is required that share-based compensation costs to be recognized based on fair value of the grant date of the award and charged to the income statement over the period it is extended. The FAS 123(R) is applicable to stock options modified, cancelled, or repurchased after January 1, 2006. Share-based compensation stock option plan, upon exercise, enables one to receive shares equivalent to the ones granted in stock purchase agreement. IT becomes risky when the holder is needed to raise the requisite cash to pay for the exercised shares. Moreover, the holder may also end up paying income tax as a result of exercising the stock option.
Share-based stock-appreciation rights plan, on the other hand, the holder is granted an amount equivalent to the increases in stock price either in cash or shares based on the company plan. SARS provide on with the right to the increase in shares value. Unlike stock options, in SARS do not require the holder to pay an exercise price. However, if one elects to receive cash, the award is regarded a liability. The CFO should recommend SARs since the holders are not charged any exercise price. SAR payable in shares is considered equity thereby credited to the equity account while SAR payable in cash is credited in the liability account.
Accounting for Leases
According to GAAP, leases should be classified into operating or capital whereby operating leases are off-balance sheet liabilities while capital leases are capitalized thereby affect both the liability and asset sides of the balance sheet. Any leases with a term of at least 75 percent of an asset’s economic useful life are termed as capital under GAAP. GAAP also requires that any asset whose lease payment is 90 percent its fair value, then it should be capitalized. Conversely, IFRS does not hold such specific thresholds. Classifying a lease as operating under IFRS instead of capital under GAAP, the difference in higher operating profit margin, lower return on assets, and higher leverage ratio.
Under operating lease, the risk of over estimating residual value as well as insurance, depreciation and taxes is bore by the lessor. Moreover, off-balance sheet financing misrepresents the financial position of a company and inflates the corporate earnings. This occurs because the management tries to misrepresent their debt. Capital leases are transferred to the lessee, who in turn has full control of the asset and the agreement carries a bargain purchase option. Capital leases unlike the operating leases make the balance sheet have more liability. Miller and Bahnson (2010) note that the off balance sheet may be risky especially when management tries to report less liability than the company has thereby end up spending more and destroying their credibility.
IAS 17 provides that any leases which transfer substantially all rewards and risks to the lessee be classified as capital and all the others as operating. The capital leases reduce the liability of a company with finance being charged to the income statement. A lease is classified depending on the transaction’s substance rather than form. The lessee has the option of purchasing the asset at a sufficiently lower price than its fair value. Further, the lessee can use the leased assets without major modifications. Miller and Bahnson (2010) assert that the lessee also has the option for a secondary rent period at a substantially lower price than the market rent. On the other hand, if the lessee bears the lessor’s losses if the lessee is entitled to cancel the lease. Moreover, the lessee bears any losses from residual fall fair value fluctuations through rebates.
Statement of Audit Standards, SAS 99
This is a legislation on financial statement frauds and terms inventory write down as a fraud according to IRS standards. Implementation of the SAS 99 results into restatement of statement with regard to the Sarbanes Oxley Act 404 with financial controls soundness influencing the decision for restatement to investors. It is recommended that new provisions for write down inventory pertaining to goods in stock be restated. Moreover, error rectification through restatement is effective in providing the reasons for financial statement errors.
Misstatement may occur due to failures in classifying items in the statement of cash flows, income statement or the balance sheet. Equity errors occur due to improper methods of accounting for warrants, stock-based compensations, earnings per share, stock options realizable by employees, and convertible securities. Revenue misstatement occur due to completion percentages, consignee transactions, repurchase obligations transactions as well as bill-and-hold transactions (Scholz, 2008). Misstatement may result entity-stakeholder dissociation. Losses accrued on write down inventory for held stack values should be reported in the statements as part of the cost of goods sold as long as the amount is relatively small. However, if the amount is relatively large, it should be reported in the income statement as a separate item.
Economic Effects of Restated Financial Statements
Restatement ensure that entities maintain integrity. The reasons for restatements may occur due to changes in market dynamics are usually due to revenue recognition, equity errors, and recognition of expenses. Overstatements of net incomes may result from improper methods of expense recognition. Cookie jar reserves may be set to manipulate revenues accruable and recognizable by an entity. Understatement of revenue is done through an overstatement of the closing inventory to decrease the cost of goods sold. Moreover, entities may fail to report and record expenses through accrual, capitalization, or deferral methods thereby understating the revenue recognized.
However, restatements may make an entity less attractive to investors and fail in anticipated takeover. It may show creditors that the entity has likelihoods of fraud occurrences and material errors thereby making them shy away from funding the company. Moreover, the existing creditors may find it hard to get back their funds. It may prove hard for the entity to acquire a global partner since material misstatements show risks to investors (Scholz, 2008). The employees’ integrity may also be watered down by material restatement. Restatements are also as a result of management’s failure in internal governance structures, which affects customers’ trust to the entity.